February 05, 2004

Deficit Coverage: What's Missing?

"Ronald Reagan proved that deficits don't matter," snapped Vice President Richard Cheney to about-to-be-fired Treasury Secretary Paul O'Neill a little over a year ago. He's wrong – as wrong about deficits as he was about Ahmad Chalabi's popular support in Iraq or Saddam Hussein's capability to threaten America. Deficits do matter.

How much do they matter? How much they matter is what's missing from the mainstream press. In fact, you'll have a hard time finding deficit forecasts by reading the mainstream press.

You'll have an easy time finding the Bush administration's official deficit forecast for 2009: $237 billion. But reading through the news section of the Washington Post will tell you almost nothing more. You will read uncontradicted quotes from OMB head Josh Bolten about how "with Congress' help in enacting the budget… we will be well on the path to cutting the deficit in half within five years." You'll come away with the (false) impression that the Bush budget manages to do this and provide $1.24 billion in tax cuts too. You'll find news reporters writing with a straight face about Bush's "confidence" that the deficit can be halved by 2009 alongside big boosts in Defense and Homeland Security spending and the extension of all the Bush tax cuts.

You'll do somewhat better with the news pages of the New York Times: Edmund Andrews will tell you that "tough surgery on... spending... produce[s] only a tiny reduction in the... deficit," and that there are enormous unreported deficits after 2009. But you'll have to read down to and beyond the twelfth paragraphs of articles to learn that neither Democrats nor Republicans in Congress find the Bush forecast credible. Only the Wall Street Journal dares tell its readers in any article's first paragraph that the Bush budget is "fiscal sleight of hand."

You'll do much better with the editorial pages (except the Journal, of course). The Post writes of "Bogus Budgeting," and says "the likely deficit in 2009... more than $150 billion higher... the administration's fuzzy math." The Times writes of the "Pinocchio Budget" with its "central fiction... that it constitutes the first step in halving the... deficit." (And the Journal calls it the "best budget of [Bush's] tenure.")

But even the closest reading of the mainstream daily media to the very last paragraphs of articles won't give you more than a vague picture of what the deficit is likely to be. And we need to have a sharper picture. Make no mistake: the Bush administration's current tune in public is very different from what Cheney says in private. In public it says that reducing the deficit is one of its highest priorities. But don't be fooled. Cheney has carried the day.

So let me fill in what's missing, and give an honest forecast of what the policies the Bush administration espouses are likely to do. The honest forecast is for a deficit of $400 billion in 2009, rising to $600 billion in 2014, and then rising still further thereafter.

What effects will these deficits have on the American economy? The media tell you that deficits are bad. They may even tell you that deficits slow growth, and raise the chances of a financial crisis that will turn into not a recession but a depression. But we need to have a sharper picture. So let me once again fill in part of what's missing. I cannot put a number on the chance that Bush deficits will trigger a financial crisis and a depression. But I can put a number on how the growth slowdown: big enough to cut an average American family's income by $4,000 by the end of the standard 10-year budget forecast period.

Think of it that way: George W. Bush wants to give your family a $4,000 annual pay cut in a decade.

How will this happen? A deficit means that the government is spending more than it takes in through taxes. A government that spends more than it takes in borrows. Savers – households, banks, and businesses – buy Treasury bonds. Each dollar of savings used to buy these Treasury bonds and thus snarfed up by the Treasury is a dollar that cannot be used to finance the building of a house, the purchase of a machine tool to boost a factory's productivity, or the replacement of an outdated inventory-control system with a cheaper high-tech one. A bigger deficit means less investment in America. And less investment in America means slower economic growth.

Now this year's deficit isn't a mistake, or at least isn't a big mistake: we shouldn't worry about this year's, or next year's deficit. As long as unemployment is high and capacity utilization low, a deficit is a good thing, but over the long term, as N. Gregory Mankiw, current chair of Bush's Council of Economic Advisers (CEA), put it: the fact that budget deficits slow economic growth is "the most basic lesson about budget deficits." This lesson "follows directly from their effects on... supply and demand.... When the government... [runs] a budget deficit, the interest rate rises, and investment falls. Because investment is important for long-run economic growth, government budget deficits reduce the economy's growth rate."

By how much? Mankiw and Federal Reserve economist Doug Elmendorf – a Clinton administration official at the Treasury Department – have some crude rules of thumb. Each dollar of deficit reduces economic growth enough to reduce America's real GDP by seven cents. The $400 billion deficit of 2009 will lower GDP that year by $28 billion – and GDP will stay $28 billion lower than otherwise in all subsequent years: that lost economic growth will not be made up.

Apply this rule of thumb to honest forecasts of what Bush administration policies will do, and find that by 2014 deficit-induced lower investment and slower economic growth will leave America's GDP some $300 billion a year lower than it would have been otherwise. A lot of the benefits from what would otherwise have been higher investment – a lot of the buildings and machines that would have helped America's workers do their stuff – will simply not be there. Productivity will be lower. And wages will be lower. That's $4,000 per family in lost income every year. That's a lot of clothes dryers not bought, a lot of vacations not taken, a lot of doctor's visits not made, a lot of old cars driven into the ground for an extra two years. That's a poorer America with less money to fund education or environmental cleanup. That's what will be missing.

And what will we have in exchange? Big cuts in taxes for the $300,000-plus-a-year crowd, profits for politically well-connected companies, and very little else. It looks to me at least like a very bad bargain.

This is not a partisan view. From the left my friends will point out that faster economic growth is not the only thing, and that budget surpluses plus faster capital accumulation are not worth the price they cost if they are funded by cuts in education or public investment or the safety net. And they are right. But they will also admit that budget surpluses and higher investment are better than tax cuts for the $300,000-plus-a-year crowd.

From the right my friends and non-friends will say that well-designed tax cuts that improve incentives could boost production by enough to outweigh the drag of deficits for a decade or so, but they will also admit that the Bush tax cuts are not the well-designed incentive-compatible ones they have in mind.

Everyone else will have few problems with what I have written. After all, it is what the chairs of Bush's CEA teach their classes when they are at their academic jobs. It is what O'Neill begged Cheney to help him get Bush to understand. It is what Bolten and NEC Chair Stephen Friedman and current Treasury Secretary John Snow said before they joined the Bush administration. Why aren't they effective on the inside in getting policies like those they used to advocate when they were on the outside? That's really what's missing.

Beautiful framework -- ought to be worked again and again until large numbers of people have a good grasp of it. That's necessary if democracy is to work better -- you know, clown shows don't make democracy even with truly free elections...

Back in 96 working on a congressional campaign I got us some attention touting the percentage of personal income tax revenue (the only taxes republicans care about) that had to go to pay interest on the debt. It was then 44%. It seemed pretty straightforward to claim that the result of the Reagan-Bush deficits was that Taxes had to be 44% higher as a result.

I don't have the current budget numbers handy to do the calculation but it seems like it would be pretty easy for you to calculate how the percentage for the 5 and 10 year budgets using both administration and reasonable projections and fair interest rate estimates. Given the impact of the Bush tax cuts on income tax receipts I expect that number will be truly staggering.

Since the pre Bush projections had the entire public portion of the debt paid off by that time it seems to me this would be an emminently understandable way to explain the direct (if not the economic) impact of the deficits in a way that would cut with voters.

I would like to see some analysis or comments about the point that we are borrowing the funds
to finance the deficit from foreigners -- not
ourselves -- and that raises a major risk that
does not exist when it is just your children or grandchildren will be the ones that have to repay it. If we are borrowing from ourselves the debt can always be extended or rolled over, but
since we are borrowing from foreigners extending or rolling over the debt may be much more difficult. It gives foreign investors and central banks a power over the US that makes the threat from Weapons of Mass Destruction pale by comparison.

"I would like to see some analysis or comments about the point that we are borrowing the funds
to finance the deficit from foreigners...."

Since the borrowing is in dollar terms there is little problem per se. Rather than thinking we are at the mercy of Europeans or Asians, the problem is more subtle. We are saving too little, they are buying American assets and will gain the income from those assets. We can look forward to relatively less income from our investments abroad. Also, as we gain debt we are likely to pay a higher relative interest rate to sustain the borrowing.

Worrying about a cashing in of American securities by international investors is not worth the while. Worrying about too little American saving is important!

Another potential item of interest: in 2014, the
average family will lose $4k in salary from the
incipient budgetary train wreck. How does that
compare to the value of the tax cut that family is
getting?

Even more interesting: is it possible to plot, as
a function of family income, both the value of a
family's tax cut and the lost salary value from
the deficits? I guess this is another form of the
"Bush tax" -- it would be interesting to me to see
whether I'm "buying" $300/year in tax cut by
"paying" $4000/year in salary -- especially if some other people, with much larger incomes, are getting back more than they are paying!

"Any concern with regard to the transfer of wealth from the US to Europe, Asia and the devloping countries?"

There is my signal concern. There is an asset transfer to international ivestors since we are saving tooo little. Private saving is low and declining, while there is a rapidly growing public deficit. The difference can be made up from abroad, though at relatively higher interest rates than would otherwise be found, but we are giving up future income.

This has to be an important middle class problem in future. We are not in the position of a country that borrows in Euros or Yen however. We borrow dollars and will pay in dollars.

"As long as unemployment is high and capacity utilization low, a deficit is a good thing"

I know why you are saying this, however. Running a deficit is only worthwhile if the money from that deficit is PRODUCTIVELY INVESTED. Where is the evidence for that, given slack capacity? What if the deficit is being productively invested in China and India to speed the movement of mfg and computer jobs? That only exacerbates the slack capacity at home and the "jobless recovery". Then there is the issue of creating government debt obligations that are a further drain on the treasury and will compete for capital during more rapid expansion.

Running a deficit today gives us less wiggle room in the future. From that POV, running a deficit today that is not educating the workforce, not improving the health of the workforce or not improving the basic infrastructure only makes it more difficult to do those things in the future when those projects would have to compete for labor as well as capital.

The deficit is a concern, not because it is a deficit, but because it is a misallocation of revenues. Yes, running a deficit could be excused. But running THIS DEFICIT to THIS LEVEL is INEXCUSABLE. Revenues are allocated to tax cuts for the wealthy with near zero economic stimulation instead of to debt reduction or to productive infrastructure initiatives that utilize the slack labor now available. That is not a good reason to run a deficit.

I hate to be picky but you seem to have spelled o'Neil's name O'Neill while recommending him for sect of treasury. I never ever ever expected to correct your spelling, especially after spelling Gulbuddin Hekmatyar Gulbudin Hekmatyar (blush).

Also don't you think that while asking Bush about SEC overreach a little question or two about Harken would be nice. As in

"could you explain to our listeners how the ENRON non arms length deals with partnerships of officers worked given you experience getting nailed for exactly that scam when on the audit committee of the Harken energy board in the case of Aloha petroleum?"

"When you complain of SEC over reach does that mean that you think they should let corporate criminals walk free like your dad's SEC did when you were caught insider trading ?"

(selling shares immediately after the Harken council said officers shouldn't sell shares).

You claimed that you invaded Iraq because there were WMD there. Fortunately there weren't. If they had been do you think the coalition forces would have secured them quickly or do you think that the Iraqi insurgents might well be using them now. Doesn't the difficulty fighting insurgents armed with conventional weapons suggest that it is a terrible idea to invade a country full of WMD controlled by an evil but deterable dictator.

"I would like to see some analysis or comments about the point that we are borrowing the funds
to finance the deficit from foreigners...."
There was a front page article on this in the 2-5 WSJ. The percentage of U. S. government debt owned by foreigners is 37.9 percent compared with 4.7% in 1965. Asian central banks aqre looking to dump this debt because of its low return and the decline of the dollar. There are several points to this.
1) Right now purchases of government securities by Asian Central banks are proping up bond prices and keeping long term interest rates low. (Despite the deficit).
2) Dollar purchases especially by the bank of Japan have probably prevented the dollar from sinking lower. Or have slowed this pace. Basically when these banks do this they purchase US debt and this exacerbates the foreign ownership of debt, and keeps long term interest rates low.
3) That the efforts by these banks to shore up the dollar are probably futile and will collapse. This in turn has the potential for a second world financial crisis. This one though not only involving Asian countries, but featuring a preciptous decline in the dollar, fears about US solvency, and a sell off of this debt. (I feel this is a distant possibility).

More likely is that the holding of such large amounts of debt by anyone, at current interest rates, and with the dollar declining is noit sustaibable. In that case we can look for a rise in long tertm interest rates at the very least.

I would love to see the blog find room for more discussion of really exciting crowd pleasing issues such as

1. the explanation of the low long term interest rates, and possible explanations, including L. Boyd's. Extending the discussion to the current yield curve (did I get that right? I meant the relationship between short and long term interest rates) what is controlling it right now, and any hints it has for our immeidate future). It seems to me that a few months ago the Fed lost the ability to control anything but very short term interest rates, and now the long term rate has mysteriously fallen. How come?

2. The productivity growth debate. I would like to hear more discussion of how we could determine exactly what the real level of productivity growth is, in which sectors it is growing faster and slower, and implications of different levels of productivity growth.

3. Real wage growth and inequality of income and wealth. How and why. Should we just accept the changing distribution (and tax-soak the rich to fix it if need be) or should we try to look towards more fundamental underlying causes and fix those. (This would also be an excuse for me to post some quotes from the Founderd denouncing the unequal distribution of income and wealth, and saying how extreme inequality is incompatible with a democratic republic.)

It seems to me that those are three critical issues for how deep the US is in over its head fiscally and socially, or if it is over its head at all.

4. I like DeLong's posts on some of the underlying theory behind "market magic" we all love. For example, I loved his post on the influence of wealth on the free market allocations. I hate the form, and slogging throgh those Platonic dialogs is not my idea of fun reading, but I love the substance.

Anne -- in the immediate sense, what you say about debts being denominated in Dollars seems true. If the Dollar stops being the reserve currency, though, and companies can get better interest rates elsewhere, do you think we'll notice that we're screwing up the balance sheets for our whole economy before it's too late? Or will 90% of Americans only find out that we've been borrowing in Euros once our currency takes a hit, Washington having been passive as it happens?

I'm just a simple trader of fx and fixed income. While I follow the theoretical logic here, reality in my world is nothing like this. Further confusing me is this is not a new reality. So what gives, is this an accident waiting to happen ? If so, why has it not yet happened, when could it happen, and what could prevent it from happening going forward ? As in Whats Missing ?

"I'm just a simple trader of fx and fixed income. While I follow the theoretical logic here, reality in my world is nothing like this. Further confusing me is this is not a new reality. So what gives, is this an accident waiting to happen ? "
I'm simply not sure about this being an accident waiting to happen but one should consider the following.
1) Most of the holders of this debt, central banks in Asia, are buying dollars in attempt to prop up the dopllar and preserve exchange rates. I think this is an impossible task and is precisely the sort of thing that gets Central Banks in trouble. Remember Britain and the pound and Soros.
2) They park some of the proceeds from these sales in U. S. Treasuries. Indeed they are the dominant players in the Treasuries market. This means they are getting a low interest rate denominated in a declining currency.
They are losing out two ways one they get paid back in cheaper dollars and they get paid back in low interest rates.
3) In response to these sales they are issueing bonds so the local currencies don't flood the local economy and cause inflation. They are backing up these bonds with reserves based U. S. treasuries. They are thus losing two ways. They are losing on U. S. Trteasury bonds and they are generally paying a high price on issueing bonds.
4) Finally we currently have a lot of U. S. bond traders playing the spread between long term bonds and short term bonds assuming that this spread will continue in the future.
None of this is very sound practice, but it could go on for years. Or one day we could wake up and see panic in the markets. And then there is all this absolutely silly discussion tthat deficitsm don't matter.